Why haven’t equity returns been higher?

Today I will eviscerate an influential “stylised fact” in finance that has arguably resulted in the misallocation of hundreds of billions of dollars of Australian savings.

The so-called “equity risk premium puzzle”, which was identified in 1985 by a Nobel prize- winning economist, purports that listed shares have historically furnished an anomalously large “excess return” over quasi risk-free assets like AAA-rated government bonds with similar duration.

The puzzle is that equities’ annual return in excess of government bonds, which Australian academic research alleges is 5 to 6 per cent over the period 1980 to 2010, is “too high” given the risk differences between the asset classes.

Another implication is that investors are unrealistically cautious: they are demanding excessively high returns to compensate them for equities’ risks.

Attempts to address the puzzle have consumed hundreds of academic papers. The practical real-world consequences have been more far-reaching.

Australia’s $962 billion corporate, industry, and public super fund sector frequently uses these excess return assumptions to justify unusually large portfolio weights to Australian and global shares, which the Organisation for Economic Co-operation and Development has highlighted as out of line with international peers.

One $40 billion fund’s default “balanced” product has just 2 per cent of its money in cash, and 9 per cent in bonds. A remarkable 50 per cent goes into Australian and global shares, with the remaining 40 per cent spread across closely correlated private equity, commercial property equity, and infrastructure equity assets.

The belief that shares offer annual excess returns of 5 to 6 per cent over government bonds also influences the market risk premium assumptions used by several government agencies, including the Australian Energy Regulator when determining acceptable gas and electricity margins.

My analysis suggests there is no puzzle. Based on the pre-tax total returns provided by the All Ordinaries Accumulation Index and Australian 10-year government bonds over the past 30 years (with reinvestment), the observed equity premium is very small. These results accord with soon-to-be-published research by Richard Heaney and Stephen Kidd, who use a similar like-for-like “holding period” approach.

I find that between 1982 and 2012 Australian shares gave a compound annual return of 12.3 per cent, with high annual volatility (or risk) of 17.7 per cent.

In contrast, Australian government bonds generated a compound annual total return of 11.7 per cent, with volatility of 8.6 per cent. (Analysis before 1980 is plagued by “survivorship biases”). The numbers are slightly different if one uses “arithmetic” rather than “geometric” returns, which is a matter of technical debate.

What is Australia’s Equity Risk Premium (March 1982 to March 2012)?

All Ords Accumulation Index

10 Year Australian Government Bonds

Annual Pre-Tax Equity Risk Premium

Annual Geometric Return

12.3%

11.7%

0.6%

Annual Arithmetic Return

13.4%

11.6%

1.8%

Annual Standard Deviation

17.7%

8.6%

NA

Source: Global Financial Data

Accordingly, the annual pre-tax premium of shares over bonds has been just 0.6 per cent (or 1.8 per cent using arithmetic returns).

Accounting for imputation credits might bump this up another percentage point. But these estimates are about half the conventional Australian benchmark of 5 to 6 per cent.

Given equities have displayed twice the volatility of government bonds, the puzzle might be recast to ask why their returns have not been higher. This data also implies Australian investors have not been conservative enough, which is reinforced by the equities-biased portfolio decisions of super funds. Interestingly, less sophisticated self-managed super fund investors appear to have been getting things right with their substantially higher cash weights.

Reviewing the literature on the puzzle reveals a common asymmetry. Academics are evaluating apples with oranges.

Specifically, they contrast the yield-to-maturity interest rates on government bonds with the holding period “total returns” (ie, dividends plus capital changes) supplied by shares. They ignore changes in the capital values of bonds, which can be a vital part of the asset’s total return.

Over the past year, the average yield on a 10-year Australian government bond has been about 3.9 per cent. Yet Bloomberg data shows that the total returns to owners of these same bonds have been greater than 15 per cent. The stellar capital gains of Aussie government bonds are one reason local fixed-income fund managers have done so well.

The flaw in the research probably relates to a misunderstanding of the differences between debt and equity. They share similarities: debt and equity are both forms of finance which, added together, equate to a company’s “enterprise value”.

They both supply investors with a claim over future cash flows.

In the case of debt, the prior-ranking return you receive is a pre-set interest rate, which may be fixed or floating, which the entity services out of its before-tax cash flows prior to paying equity holders.

Buying a share gives you a fractional entitlement to any earnings the entity may (or may not) distribute. You are not guaranteed a return, which may end up being highly positive or negative.

The intrinsic value of debt and equity investments is equal to the present value of their discounted future interest repayments and dividends, respectively.

A key distinction is that where bonds have a maturity, shares are perpetual and offer no certainty of income.

The reason you get a capital gain on a share is typically if one of three things happen: the company’s projected dividends are expected to be higher than when you invested; the risk imputed to those dividends declines; and/or discount rates fall.

Similar principles apply to bonds. If the market believes that a bond’s interest and principal repayments have a lower risk of default than when you invested, the bond’s price will rise, giving a capital gain.

This is one reason our government bond prices have surged in recent times. In a world of escalating risks, Australia’s credit has seemed relatively safe.

Conversely, if the market thinks a bond’s repayments are less certain, as in southern Europe, prices will fall, triggering a capital loss.

For years I’ve called on Treasury to publish best practice asset-allocation models against which to benchmark super funds. Ken Henry now seems to believe this is an important issue. Hopefully his successors will listen.

Christopher Joye is an economist, policy adviser and fund manager.

The Australian Financial Review

BY Christopher Joye

Christopher Joye is a contributing editor to The Australian Financial Review. He is a leading economist, fund manager and policy adviser who has previously worked for Goldman Sachs and the RBA, and was a director of the Menzies Research Centre. He is currently a director of Smarter Money Investments.

BY Christopher Joye

Christopher Joye is a contributing editor to The Australian Financial Review. He is a leading economist, fund manager and policy adviser who has previously worked for Goldman Sachs and the RBA, and was a director of the Menzies Research Centre. He is currently a director of Smarter Money Investments.